EXECUTIVE SUMMARY

The one Thing, which is rising Week after Week, Mouth after Mouth and
which has given the Sleepless Nights to 100 days of Congress Government, which
affects from Prime Minister to Common Man. YES, IT IS INFLATION. Inflation
is commonly understood as a situation of substantial and rapid general increase in
the level of prices and consequent deterioration in the value of money over a period
of time. In other words inflation usually refers to a persistent and rapid rise in the
general price level, which reduces the value of money or its purchasing power over
a period of time.

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 (A) MEANING:
Inflation is commonly understood as a situation of substantial and rapid general
increase in the level of prices and consequent deterioration in the value of money over a
period of time. In other words inflation usually refers to a persistent and rapid rise in the
general price level, which reduces the value of money or its purchasing power over a
period of time.
(B) DEFINITION:
According to Crowther, “Inflation is a state in which the value of money is
falling i.e. prices are rising.”
How to Measure Inflation If the price level in the current year is ‘P1’ & in the
previous year is ‘Po’, then inflation for the current year is
Inflation = P1- Po * 100
po

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 FEATURES OF INFLATION
1. Inflation leads to persistent remarkable and continuous rise in general price
level.
2. Inflation is a scarcity oriented.
3. Inflation is a dynamic phenomenon. It is not a state of high prices, but a
process of rising prices.
4. Inflation is a state of disequilibria. It involves an imbalance between
aggregate demand and aggregate supply.
5. Inflation is a pure monetary phenomenon.
6. Real inflation takes place only after full employment. So it is a post frill
employment phenomenon.
7. Inflation is a longer period phenomenon.

TYPES OF INFLATION
Inflation is often classified on three different criteria. Firstly, one might
distinguish between various types of inflation on the basis of speed at which the
general price level rises. Secondly, one way distinguishes between open and
suppressed inflation. Finally, as we find in the modern macroeconomic theory,
inflation is classified on the basis of the factors, which induce it. On the criterion of
the rate at which the general price level rises, we have the following types of
inflation:
1. Creeping Inflation
2. Walking Inflation
3. Running Inflation
4. Galloping or Hyper-Inflation
5. Cost-Push Inflation
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6. Demand-Pull Inflation
7. Built-in Inflation
8. Chronic Inflation
9. Core Inflation
10. Headline inflation
11. Stealth Inflation
12. Assets inflation
1. Creeping Inflation
An extremely mild form of inflation is often characterized as creeping
inflation. In this case prices rise at a rate of around 2 percent per annum. In case the
rate of inflation does not register further increase, those a mild does of inflation
may not have any adverse effects on the economy. Creeping inflation sometimes
provides necessary inducement to investors. The debatable question about the
creeping inflation however, is whether it would not eventually gather momentum
and thereby creates distortions in the economy. The world has witnessed both types
of situations. Certain countries have lived with mild inflations over long periods
and their economies in these periods have registered rapid economic growth. In
other countries, creeping inflation eventually accelerated and caused the collapse of
the economy.
2. Walking Inflation
The walking inflation in terms of degree of prices rise is an intermediate
situation between the creeping and running inflations. The rate of inflation in this
case is distinctly higher than that in the case of the creeping inflation. Since the
walking inflation does not invite widespread protests, the monetary authorities do
often not take it seriously and they don’t undertake timely corrective measures. It

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also sometimes leads to balance of payments problems because on the one hand it
induces imports and, on the other discourages exports.
3. Running Inflation
The running inflation is considered to be a stage between walking inflation
and hyper-inflation. Since the hyper-inflation is often defined as a situation in
which prices rise at a rate of at least 40 percent per month. When prices rise at a
rate exceeding 4-5 percent per month the situation becomes alarming. This
inflation redistributes income to the disadvantages of the fixed income groups such
as workers, pensioners and salary earners, it is considered to be highly unjust.
Further a running inflation also creates conditions of uncertainty. If prices rises
from 10-12 percent than the economy will be collapsed and there will be no
monetary measures to prove effective.

4. Hyper Inflation
The hyper-inflation refers to a situation in which prices rise at an alarming
rate of 40 percent per month or even more. The most notable examples of hyper-
inflation are to be found in the economic histories of Germany, Austria, Russia,
Poland, Greece, Hungary and China. In hyper-inflation money loses its importance
as a store of value as no one holds it for precautionary and speculative purposes. In
fact, a hyper-inflation invariably leads to a monetary collapse and national
catastrophe. However, it is important to recognise the fact that hyper-inflation does
not arise abruptly. It is always a result of wrong policies of the government.
Whenever in some country the government indulges recklessly in unproductive
expenditures, which are largely financed by borrowing from the Central Bank of
the Country, a process of inflation begins which often culminates in hyper-
inflation.

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5. Cost-Push Inflation
Aggregate supply is the total volume of goods and services produced by an
economy at a given price level. When there is a decrease in the aggregate supply of
goods and services stemming from an increase in the cost of production, we have
cost-push inflation. Cost-push inflation basically means that prices have been
“pushed up” by increases in costs of any of the four factors of production (labour,
capital, land or entrepreneurship) when companies are already running at full
production capacity. With higher production costs and productivity maximized,
companies cannot maintain profit margins by producing the same amounts of
goods and services. As a result, the increased costs are passed on to consumers,
causing a rise in the general price level (inflation).
Management Practice under Cost-Push Inflation
To understand better their effect on inflation, let’s take a look into how and
why production costs can change. A company may need to increases wages if
labourers demand higher salaries (due to increasing prices and thus cost of living)
or if labour becomes more specialized. If the cost of labour, a factor of production,
increases, the company has to allocate more resources to pay for the creation of its
goods or services. To continue to maintain (or increase) profit margins, the
company passes the increased costs of production on to the consumer, making
retail prices higher. Along with increasing sales, increasing prices is a way for
companies to constantly increase their bottom lines and essentially grow. Another
factor that can cause increases in production costs is a rise in the price of raw
materials. This could occur because of scarcity of raw materials, an increase in the
cost of labour and/or an increase in the cost of importing raw materials and labour
(if the they are overseas), which is caused by a depreciation in their home currency.
The government may also increase taxes to cover higher fuel and energy costs,

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forcing companies to allocate more resources to paying taxes. To visualize how
cost-push inflation works, we can use a simple price-quantity graph showing what
happens to shifts in aggregate supply. The graph below shows the level of output
that can be achieved at each price level. As production costs increase, aggregate
supply decreases from AS1 to AS2 (given production is at full capacity), causing
an increase in the price level from P1 to P2. The rationale behind this increase is
that, for companies to maintain (or increase) profit margins, they will need to raise
the retail price paid by consumers, thereby causing inflation.

6. Demand-Pull Inflation
Demand-pull inflation occurs when there is an increase in aggregate demand,
categorized by the four sections of the macro economy households, businesses,
governments and foreign buyers. When these four sectors concurrently want to
purchase more output than the economy can produce, they compete to purchase
limited amounts of goods and services. Buyers in essence “bid prices up”, again,
are causing inflation. This excessive demand, also referred to as “too much money

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chasing too few goods”, usually occurs in an expanding economy. The term
demand-pull inflation is mostly associated with Keynesian economics.
Management Practice under Demand-Pull Inflation
The increase in aggregate demand that causes demand-pull inflation can be
the result of various economic dynamics. For example, an increase in government
purchases can increase aggregate demand, thus pulling up prices. Another factor
can be the depreciation of local exchange rates, which raises the price of imports
and, for foreigners, reduces the price of exports. As a result, the purchasing of
imports decreases while the buying of exports by foreigners increases, thereby
raising the overall level of aggregate demand (we are assuming aggregate supply
cannot keep up with aggregate demand as a result of full employment in the
economy). Rapid overseas growth can also ignite an increase in demand as more
exports are consumed by foreigners. Finally, if government reduces taxes,
households are left with more disposable income in their pockets. This in turn leads
to increased consumer spending, thus increasing aggregate demand and eventually
causing demand-pull inflation. The results of reduced taxes can lead also to
growing consumer confidence in the local economy, which further increases
aggregate demand.
Demand-pull inflation is a product of an increase in aggregate demand that is faster
than the corresponding increase in aggregate supply. When aggregate demand
increases without a change in aggregate supply, the ‘quantity supplied’ will
increase (given production is not at full capacity). Looking again at the price-
quantity graph, we can see the relationship between aggregate supply and demand.
If aggregate demand increases from AD1 to AD2, in the short run, this will not
change (shift) aggregate supply, but cause a change in the quantity supplied as
represented by a movement along the AS curve. The rationale behind this lack of

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shift in aggregate supply is that aggregate demand tends to react faster to changes
in economic conditions than aggregate supply. As companies increase production
due to increased demand, the cost to produce each additional output increases, as
represented by the change from P1 to P2. The rationale behind this change is that
companies would need to pay workers more money (e.g. overtime) and/or invest in
additional equipment to keep up with demand, thereby increasing the cost of
production. Just like cost-push inflation, demand-pull inflation can occur as
companies, to maintain profit levels, pass on the higher cost of production to
consumers’ prices.

7. Built-in Inflation
Built-in inflation is an economic concept referring to a type of inflation that
resulted from past events and persists in the present. It thus might be called
hangover inflation.
At any one time, built-in inflation represents one of three major determinants of the
current inflation rate. In Robert J. Gordon's triangle model of inflation, the current
inflation rate equals the sum of demand-pull inflation, supply-shock inflation, and
built-in inflation. "Demand-pull inflation" refers to the effects of falling
unemployment rates (rising real gross domestic product) in the Phillips curve
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model, while the other two factors lead to shifts in the Phillips curve. The built-in
inflation we see now started with either persistent demand-pull or large cost-push
(supply-shock) inflation in the past. It then became a "normal" aspect of the
workings of the economy due to the roles of inflationary expectations and the
price/wage spiral. Inflationary expectations play a role because if workers and
employers expect inflation to persist in the future, they will increase their
(nominal) wages and prices now. (see real vs. nominal in economics.) This means
that inflation happens now simply because of subjective views about what may
happen in the future. Of course, following the generally-accepted theory of
adaptive expectations, such inflationary expectations arise because of persistent
past experience with inflation. The price/wage spiral refers to the conflictual nature
of the wage bargain in modern capitalism. (It is part of the conflict theory of
inflation, referring to the objective side of the inflationary process.) Workers and
employers usually do not get together to agree on the value of real wages. Instead,
workers attempt to protect their real wages (or to attain a target real wage) by
pushing for higher money (or nominal) wages. Thus, if they expect price inflation
-- or have experienced price inflation in the past -- they push for higher money
wages. If they are successful, this raises the costs faced by their employers. To
protect the real value of their profits (or to attain a target profit rate or rate of return
on investment), employers then pass the higher costs onto consumers in the form of
higher prices. This encourages workers to push for higher money wages. In the
end, built-in inflation involves a vicious circle of both subjective and objective
elements, so that inflation encourages inflation to persist. It means that the standard
methods of fighting inflation using either monetary policy or fiscal policy to induce
a recession are extremely expensive, i.e., meaning large rises in unemployment and
large falls in real gross domestic product. This suggests that alternative methods

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such as wage and price controls (incomes policies) may be needed as
complementary to recessions in the fight against inflation.
8. Chronic Inflation
Chronic inflation is characterized by much higher price increases than
ordinary inflation, at annual rates of 10% to 30% in some industrialized nations
and even 100% or more in a few developing countries. Chronic inflation tends to
become permanent and ratchets upwards to even higher levels as economic
distortions and negative expectations accumulate. To accommodate chronic
inflation, normal economic activities are disrupted Consumers buy goods and
services to avoid even higher prices; property speculation increases; businesses
concentrate on short-term investments; incentives to acquire savings, insurance
policies, pensions, and long-term bonds are reduced because inflation erodes their
future purchasing power; governments rapidly expand spending in anticipation of
inflated revenues; exporting nations suffer competitive trade disadvantages forcing
them to turn to protectionism and arbitrary currency controls.
9. Core Inflation
Core inflation is a measure of inflation which excludes certain items that
face volatile price movements e.g. food. The preferred measure by the Federal
Reserve of core inflation in the United States is the core Personal consumption
expenditures price index. This is based on chained dollars.
Since February 2000, the Federal Reserve Board’s semi-annual monetary policy
reports to Congress have described the Board’s outlook for inflation in terms of the
PCE. Prior to that, the inflation outlook was presented in terms of the CPI. In
explaining its preference for the PCE, the Board stated the chain-type price index
for PCE draws extensively on data from the consumer price index but, while not
entirely free of measurement problems, has several advantages relative to the CPI.

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The PCE chain-type index is constructed from a formula that reflects the changing
composition of spending and thereby avoids some of the upward bias associated
with the fixed-weight nature of the CPI. In addition, the weights are based on a
more comprehensive measure of expenditures. Finally, historical data used in the
PCE price index can be revised to account for newly available information and for
improvements in measurement techniques, including those that affect source data
from the CPI; the result is a more 12 consistent series over time. —Monetary Policy
Report to the Congress, Federal Reserve Board of Governors, Feb. 17, 2000 The
older preferred measure of inflation in the United States was the Consumer Price
Index. This is still used as the indicator for most other countries, and is presented
monthly in the US by the Bureau of Labor Statistics. This index tends to change
more on a month to month basis than does "core inflation". This is because core
inflation eliminates products that can have temporary price shocks (i.e. energy,
food products). Core inflation is thus intended to be an indicator and predictor of
underlying long-term inflation. The concept of core inflation as aggregate price
growth excluding food and energy was introduced in a 1975 paper by Robert J.
Gordon. This is the definition of "core inflation" most used for political purposes.
Analysis by the Federal Reserve Bank of New York indicates that this measure is
no better than a moving average of the Consumer Price Index as a predictor of
inflation. There are also other types of measuring inflation rates. In the United
States the Dallas Federal Reserve computes a trimmed mean PCE price index,
which separates "noise" and "signal". This is trimmed at 19.4% at the lower tail
end and 25.4% at the upper tail. The Cleveland Federal Reserve computes a
Median CPI and a 16% trimmed mean CPI. Trimmed means that the highest rises
and declines in prices are trimmed by a certain percentage, attributing to a more
accurate measurement on core inflation. In relation to this, the Median CPI is

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usually higher than the trimmed figures for both PCE and CPI. There also is a
median PCE, but is not used for any purpose in determining inflation.

10. Headline Inflation

Headline inflation is a measure of the total inflation within an economy and is
affected by areas of the market which may experience sudden inflationary spikes
such as food or energy. As a result, headline inflation may not present an accurate
picture of the current state of the economy. This differs from core inflation which
excludes factors, such as food and energy costs.

11. Stealth Inflation

Stealth Inflation is the term used to describe charges and fees created by
business to gain extra profit and revenue from its customers. The stealth part of the
term is that business will often use miscellaneous fees to charge customers without
the customers consciously knowing the fees existed, even though they may have
agreed then signed a contract for the goods and services the fee is hidden in a
mirage of words and policies. The inflation part of the term relates to the up
charging of the service without actually providing anything additional. Since most
companies charge a fee to accept payment a portion gets built into profit and
revenue. A big example of stealth inflation can be overdraft fees from banks
surcharges from Telco providers, processing fees and installation fees.

12. Assets Inflation

Assets inflation is an economic phenomenon denoting a rise in price of
assets, as opposed to ordinary goods and services. Typical assets are financial

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instruments such as bonds, shares, and their derivatives, as well as real estate and
other capital goods.

CAUSES OF INFLATION
For controlling the rates of commodity, we must know why these rates are
rising i.e. inflating which means what are the reasons or causes behind inflation.
There are various factors which causes inflation in the economy which is as
follows:
a. Monetary Factors
b. Non Monetary Factors
c. Structural Factors

MONETARY FACTORS
1. Expansion of Money Supply
This is the basic factor, which causes inflation. Due to increase in expansion
of money supply, there is increase in demand of luxurious commodities. Credit
facilities allotted by bank are also the result of inflation. Deficit financing also
contribute to the growth of inflation.
2. Increase in Disposable Income
When the disposable income of people increases, demand for real goods and
services increases, causing a rise in price leading inflation.
3. Increase in Consumer Spending
As the income of the consumers rises, they spend more due to expenditure
consumption or demonstration effect, which raises the aggregate demand causing
inflation.
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4. Development and Non-Development Expenditure
The expenditure for the development of huge plants and projects will
increase the demand for factors of production resulting in inflation. On the other
way, the expenditure for the non-development like defence expenditure will create
shortages of consumption goods resulting inflation.
5. Indirect Taxes
Due to high indirect taxes, sellers increase the price of their products to
recover the tax from the consumers, which indirectly leads to inflation.
6. Demand for Foreign Commodities
When the demand for the foreign commodities increases, the supply for the
home commodities decreases which leads to increasing the price.

NON-MONETARY FACTORS
1. Rising Population
As population of the economy increases, demand for better goods increases,
this causes inflation. So, rising population is the foremost non-monetary factor
resulting inflation.
2. Natural Calamities
Due to the occurrence of natural calamities like floods, famines, bad
weather, etc results in crop failure, which leads to rising price.
3. Speculation and Black Money
Speculation, hoarding and black money also causes inflation, as such
unearned money is spend lavishly by people, creating unnecessary demand for
goods and services.
4. Unfair Practices by Monopoly Houses

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 The monopoly houses prefer to restrict outputs of their products and raise
their prices to enjoy excess profits leading to inflation.
5. Bottlenecks and Shortages
Bottlenecks i.e. blockages and shortages of various kinds destruct the
process of the economic development. As a result of shortages, price rise.
STRUCTURAL FACTORS
1. Capital Shortage
This is due to a very low rate of capital formation in a poor country where
vicious circle of poverty exists.
2. Infrastructural Bottlenecks
Power shortages, inefficient transport, underutilization of capacities and
resources, etc are obstruction to the economic growth of the country, which leads
to the price rise and finally inflation.
3. Limited Efficient Entrepreneurs
Entrepreneurs do not possess spirit to undertake risky projects. Investments
are generally made in trade and unproductive assets like land, gold etc. Hence
when supply of money is increased, output of real goods and services does not
increase which leads to inflation.
4. Lack of Foreign Capital
The unfavorable terms of trade and deficit in balance of payments have
further increased the problem of rising prices.
5. Imperfections of the Market
Immobility of factors, rigid prices, ignorance of market conditions etc all
these does not allow the resources to utilize properly so rising prices due to
increase in supply and without increase in real output.

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 TRACE THE EFFECTS OF INFLATION

Economic Effects of Inflation

Inflation is a very unpopular happening in an economy. Inflation is the most
important concern of the people as it badly affects their standard of living. Some
America presidential candidates called ‘Inflation As Enemy Number One’ High
rate inflation makes the file of the poor very miserable. It is therefore described as
anti-poor. Inflation not only disrupts the economy but also prepares ground for
social and political upheavals. The effects/consequences of inflation are as
followers:
1. Effects on production
The condition or fact of being operative or in force on production can be
divided into two categories the stimulating or effect and the disastrous effect.
a) Stimulating or Favourable Effect
Because of the effects on production it has been observed that mild inflation
or gently rising prices have a stimulating or a tonic effect on the economy. When
price rise profits increases, investment increases that generates income and creates
employment as a results output expands. This process continues up to the point of
full employment.
b) Disastrous or Unfavourable Effects

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 If money supply increases beyond the point of full employment, it would
lead to a galloping or hyperinflation and results in disastrous effects on the
economy:
1. Uncontrolled inflation leads to discouragement in savings due to falling
value of money.

2. Energies of business community are diverted to speculation and making

quick profits rather than genuine production i.e. encourages speculation.
3. Inflation encourages the hoarding and black marketing
4. Inflation also affects Misallocation of Resources
5. Flight of capital is encouraged due to fall in money the investors prefer to
invest abroad.
6. Consumers suffers as seller’s market will be developed if price of all type of
goods rise of any quality.
7. Distortions and Maladjustments in the production dispute the working of the
price systems in the system in the economy.

2. Effects of inflation on income distribution

Inflation is socially undesirable. It redistributes wealth in favour of the rich
at the cost of poor it makes the rich richer and poor poorer. The people whose real
incomes erode during inflation are the victims of inflation. a] As the value of
money falls the burdens of debt is reduced and debtors gain creditor suffer because
in real sense they receive less during inflation. b] Fixed income groups like salaried
class and pensioners are hit hard during inflation. c] Business community
welcomes inflation as they earn super normal profits. d] Investors in shares benefit
during inflation small savers, small investors and class lose during inflation. e]

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Farmers gain in inflation by prices of agriculture prices commodities rise and costs
paid them lag behind prices.

3. Effect of inflation on consumption and welfare

Inflation reduces the economic welfare of the fixed income groups as the
price raises the purchasing power of money falls hence the people get a smaller
amount of goods services or low quality for the same amount of money. As a result
their consumption would fall and the standard of living. Hence galloping inflation
is the ‘Cruelest tax of all’.

4. Effects of inflation on foreign trade

Inflation affects adversely the Country’s balance of payments situation when
prices are raising foreign demand for our goods will fall and exports declined due
to high prices domestic consumers buy foreign goods and imports rise hence
unfavorable balance of payments.

5. SOCIAL AND POLITICAL EFFECTS

a. The antisocial elements get rewarded and the masses suffer during inflation.
b. Inflation disrupts social life by favouring rich and black market.
c. The standard of business morality go down during inflation.
d. People lose faith in democratic government due to inflation.

6. Effects on manufacturers
Inflation is harmful to trade. Manufacturers generally sell goods on credit.
When they seek repayment they find that the money they receive is less than they
expected. They therefore become reluctant to trade.

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MEASURES TO CONTROL INFLATION
These are the following actions taken to control inflation
1) Monetary Measures
2) Fiscal Measures
3) Other Non-monetary Measures

1) MONETARY MEASURES
a) Quantitative Methods
i. Raising the Bank Rate
To control inflation the central bank increases the bank rate. With this the cost
of borrowing of commercial banks from central bank will increase so the
commercial banks will charge higher rate of interest on loans. This discourages
borrowings and thereby helps to reduce the money in circulation.
ii. Open Market Operations
During inflation, the central bank sells the bills and securities. These cash
reserves of commercial banks will decrease as they pay central bank for purchasing
these securities. Thus the loan able funds with commercial banks decrease which
leads to credit contraction.
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iii. Variable Reserve Ratio
The commercial banks have to keep certain percentage of their deposits with the
central bank in the form of cash reserve. During inflation, the central bank
increases this cash reserve ratio this will reduce the lending capacity of the banks.

b) The Qualitative Methods

i. Fixation of Margin Requirements
Commercial banks have to maintain certain fixed margins while granting loans.
In inflation central bank raises the margin to contract credit and reduce the price
level.
ii. Regulation of Consumer Credit
For purchase of durable consumer goods on installment basis rules regarding
payments are fixed. During inflation and initial payment is increased and the
number of installments are reduced. These results in credit contraction and fall in
prices.
iii. Control through Directives
Certain directives are issued by central bank to commercial banks and they are
asked to follow them while lending. This keeps in check the volume of money.
iv. Rationing of Credit
The central bank regulates the amount and purpose for which credit is granted
by commercial banks.
v. Moral Suasion

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 This refers to request made by central bank to commercial banks to follow its
general monetary policy.
vi. Direct Action
Direct action is taken by central bank against commercial banks if they do not
follow the monetary policy laid by it.
vii. Publicity
The central bank undertakes publicity to educate commercial bank and public
about the trends in money market. By undertaking these measures the central bank
can control the money supply and help to curb inflation.
2) FISCAL MEASURES
a. Taxation
The rates of direct and indirect taxes may be raised and new taxes may be
imposed. This policy will reduce the disposable income in the hands of the people
and their expenditure.
b. Public Expenditure
During inflation, the government should reduce its expenditure. This would
reduce the income in the hands of some people. Hence the effective demand would
decrease.
c. Public Borrowing
The government may resort to voluntary and compulsory borrowing. This
policy reduces the income in the hands of some people. Hence the effective
demand would decrease.
d. Over Valuation of Domestic Currency
Over valuation of domestic currency makes exports costlier and there is a fall in
the volume of exports. Imports also become cheaper and there is an increase in
money supply causing a fall in prices.

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 e. Inducement to Save
The government should induce savings through incentives. This will reduce the
supply of money and purchasing power of the people causing a fall in prices.
f. Public debt management
The public debt should be handled in such a way that there is no increase in the
supply of money. Hence the surplus in the budget should be used to repay the
public debts.

3) NON –MONETARY MEASURES/OTHER MEASURES

1. Increase in output
Every country suffering from inflation should take steps to increase the
output of scarce goods and services. The production of essential goods at the cost
of luxury goods can also serve as an anti-inflationary measure.
2. Price control and rationing
Price control must be introduced in respect of essential commodities. Also
rationing should be introduced for equitable distribution of essential commodities.
The supply of essential goods can be undertaken through public distribution system
to keep the prices in check.
3. Imports
Imports of food grains and other essential goods which are in short supply
should be allowed.
4. Legal action
Legal action should be taken against hoarders and black marketers.
5. Wage-rate

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 During inflation, the rise in wage rate should be linked to rise in labour
productivity. This will help to control inflation.

PRICE RISE STILL PINCHING COMMON MAN’S

POCKET
The 15 per cent rise in national and per capita income and a buoyant 9.4 per
cent GDP growth notwithstanding, the common man is still reeling under the
massive burden of rising prices.
In fact, excepting for just sugar, the rates of as many as 7-8 essential
commodities have shot up by over 25 per cent between January and May as against
the same period last year.
While the prices of wheat, pulses, spices and condiments, edible oil, meat &
meat products, milk products and fruits & vegetables – on an average – increased
by over 25 per cent in this period, forcing the aam aadmi to question the
authenticity of the much promised inclusive growth.
The price rises come at a time when India has witnessed a growth of 15.8 per
cent in 2006-07 in its national income from Rs 28,46,762 crore in 2005-06 to Rs
32,96,639 crore in 2006-07.

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 The primary reason for their vegetables price rise is the entry of retailers in
organised market which has been sourcing supplies directly from the farmers to
retail warehouses.
TACKLING INFLATION
Many people think it is ok to tolerate some inflation if, in return, it is
possible to sustain higher growth rates. Nothing matters as much for peace,
prosperity and poverty alleviation as high GDP growth.
However, the link between inflation and growth is complex. High inflation
does not give high growth. The growth miracles of Asia, where above 7% growth
was sustained over a 25-year period, were not associated with high inflation. In
fact, countries with high inflation have tended to have low growth.
In the business cycle, an acceleration of inflation can support a temporary
acceleration of growth. In India, expected inflation has gone up from roughly 3%
in 2004 to roughly 7% today--a rise of 4 percentage points. Interest rates have risen
by less than 4 percentage points. As a consequence, real interest rates have actually
gone down. Borrowing has become cheaper; we have a credit boom; and this is
giving heightened GDP growth.

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 If inflation now stands still at 7%, this boost to GDP growth will fade away.
Episodes where inflation went up are associated with a brief acceleration of GDP
growth. A government can jolt an economy by raising the inflation rate. This
heightened growth is not sustained. Conversely, achieving high sustained GDP
growth is about fundamental issues of economic reform, and does not
concomitantly require high inflation.
One of the great strengths of India is that the political system just does not
accept high inflation. This is one area where politicians have been ahead of the
intellectuals. Inflation of 3% is politically acceptable, and inflation above 5% sets
off alarm bells.
The government that can jolt an economy by raising the inflation rate then
has to go through the costly process of wringing out the inflation, to get back to
3%. Since there is no trade-off between inflation and GDP growth, Parliament is
right in demanding low inflation and high GDP growth.
Currently, in India, we go through boom-and-bust cycles; sometimes GDP
growth rates are very high and sometimes GDP growth rates drop sharply. This
boom-and-bust cycle is unpleasant for every household. There is a powerful
international consensus that stabilizing inflation reduces this boom-and-bust cycle
of GDP growth. The ideal combination, which has been achieved in all mature
market economies, is one involving low inflation, which is also predictable and
non-volatile. Low inflation volatility induces low volatility of GDP growth. Low
and predictable inflation also reduces the number of mistakes made by
entrepreneurs in formulating investment plans. What India does not have is an
institutional capacity for delivering predictable, non-volatile inflation of 3%. In
socialist India, the way to deal with an outbreak of inflation was to do government
interference in commodity markets. A few commodities that "cause" inflation are

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identified, and the government swings into action banning exports, giving out
import licences, banning futures trading, sending the police to unearth "hoarding",
etc. This is deeply distortionary.
Milk exports were banned, and milk prices fell. But why should milk
farmers pay for a macroeconomic problem of inflation? The cost of bringing down
inflation needs to be dispersed all across the economy. If milk prices had been
allowed to rise, then more labour and capital would shift from unproductive cereals
to high-value milk production. India has the potential to be the world's biggest
exporter of milk. But this requires a sophisticated web of producers, supply chain,
exporters, factories, etc.
This sophisticated ecosystem will not flourish when the government meddles
in the milk industry. A meddlesome government will go through the whiplash of
doing an MSP one day because milk prices are low and banning exports another
day because milk prices are high. There is something profoundly wrong about a
government that interferes in what can be imported and what can be exported. If
the export of ball bearings were sometimes banned by the government, you can be
sure there would be fewer factories to build ball bearings.
India is evolving from a socialist past into a mature market economy. How
can predictable, non-volatile inflation of 3% be achieved? The recipe that has been
developed worldwide is to devote the entire power of monetary policy to this one
task. In India, the RBI has a complex mandate spanning over many contradictory
roles. This has led to failures on inflation control.
In a mature market economy, a modern central bank watches expected
inflation with great interest. Active trading takes place on the spot and derivatives
markets, for both ordinary bonds and inflation-indexed bonds. Using these prices, a
modern central bank is able to infer expected inflation. When the short-term

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interest rate is raised or lowered, in order to respond to changes in expected
inflation, there is a slow impact on the economy, possibly spread over two to three
years.
A modern central bank has the economic knowledge required to watch out
for expected inflation deep in the future, and respond to it ahead of time, so as to
deliver inflation that is on target. In India's case, the RBI Act of 1934 predates
modern monetary economics. In other countries, fundamental reforms have been
undertaken in order to refashion monetary institutions in the light of modern
knowledge. As an example, in the late 1990s, when Tony Blair and Gordon Brown
won the election, they refashioned the Bank of England as a focused central bank
which has three core values The bad drafting of the RBI Act of 1934 is the ultimate
cause of the distress of milk producers today. These linkages are not immediately
visible, but they are very real. It is because India does not have a proper
institutional foundation for monetary policy that we are reduced to distortionary
mechanisms for inflation control.

MEASURES OF INFLATION
Inflation is measured by calculating the percentage rate of change of a price
index, which is called the inflation rate. This rate can be calculated for many
different price indices, including:
Consumer price indices (CPIs) which measure the price of a selection of goods
purchased by a "typical consumer." In the UK, an alternative index called the
Retail Price Index (RPI) uses a slightly different market basket.
Cost-of-living indices (COLI) are indices similar to the CPI which are often used
to adjust fixed incomes and contractual incomes to maintain the real value of those
incomes.

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Wholesale price index The Wholesale Price Index (WPI) is the most widely used
price index in India. It is the only general index capturing price movements in a
comprehensive way. WPI was first published in 1902, and was one of the more
economic indicators available to policy makers until it was replaced by most
developed countries by the Consumer Price Index in the 1970s.It is an indicator of
movement in prices of commodities in all trade and transactions.
Producer price indices (PPIs) which measure the prices received by producers.
This differs from the CPI in that price subsidization, profits, and taxes may cause
the amount received by the producer to differ from what the consumer paid. There
is also typically a delay between an increase in the PPI and any resulting increase
in the CPI. Producer price inflation measures the pressure being put on producers
by the costs of their raw materials. This could be "passed on" as consumer
inflation, or it could be absorbed by profits, or offset by increasing productivity. In
India and the United States, an earlier version of the PPI was called the Wholesale
Price Index.
Commodity price indices, which measure the price of a selection of commodities.
In the present commodity price indices are weighted by the relative importance of
the components to the "all in" cost of an employee.
The GDP Deflator is a measure of the price of all the goods and services included
in Gross Domestic Product (GDP). The US Commerce Department publishes a
deflator series for US GDP, defined as its nominal GDP measure divided by its real
GDP measure.
Capital goods price Index, although so far no attempt at building such an index
has been made, several economists have recently pointed out the necessity of
measuring capital goods inflation (inflation in the price of stocks, real estate, and
other assets) separately.[citation needed] Indeed a given increase in the supply of

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money can lead to a rise in inflation (consumption goods inflation) and or to a rise
in capital goods price inflation. The growth in money supply has remained fairly
constant through since the 1970's however consumption goods price inflation has
been reduced because most of the inflation has happened in the capital goods
prices.
Regional Inflation The Bureau of Labor Statistics breaks down CPI-U
calculations down to different regions of the US.
Historical Inflation Before collecting consistent econometric data became
standard for governments, and for the purpose of comparing absolute, rather than
relative standards of living, various economists have calculated imputed inflation
figures. Most inflation data before the early 20th century is imputed based on the
known costs of goods, rather than compiled at the time. It is also used to adjust for
the differences in real standard of living for the presence of technology. This is
equivalent to not adjusting the composition of baskets over time.
INFLATION & INDIA (WPI)
The Wholesale Price Index (WPI) is the most widely used price index in
India. It is the only general index capturing price movements in a comprehensive
way. WPI was first published in 1902, and was one of the more economic
indicators available to policy makers until it was replaced by most developed
countries by the Consumer Price Index in the 1970s.It is an indicator of movement
in prices of commodities in all trade and transactions. It is also the price index in
India which is available on a weekly basis with the shortest possible time lag of
two weeks. It is due to these attributes that it is widely used in business and
industry circles and in Government and is generally taken as an indicator of the
rate of inflation in the economy. The current series of Index Number of Wholesale
Prices in India with 1981-82 as base year came into existence from July 1989. With

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a view to reflecting adequately the changes that have taken place in the economy
since 1981-82, the Government appointed a Working Group to revise the existing
WPI series and to examine the commodity coverage, selection of the base year,
weighting diagram and other related issues. WPI is the index that is used to
measure the change in the average price level of goods traded in wholesale market.
The new series with 1993-94 as the base has as many as 435 items in the
Commodity basket. To reflect the structural changes in the economy that have
taken place over a decade, a large number of commodities have been added and a
few with diminished importance have been dropped. In the revised series, “Primary
Articles” contribute 98 items, “Fuel, Power, Light and Lubricants” 19 items, and
“Manufactured Products” provide 318 items. The number of price quotations in the
revised series is spread out to as many as 1918 quotations. In all, there are 136 new
items in the revised series. Out of that, Primary Articles account for 13, Fuel Group
contributes 1 and Manufactured Products have 122 new commodities. The revised
weights of the three major groups are given below. Figures in the parentheses are
the weights of the respective groups in the 1981-82 series.
 Primary Articles
 Fuel, Power, Light & Lubricants
 Manufactured Products
India uses the Wholesale Price Index (WPI) to calculate and then decide the
inflation rate in the economy. Most developed countries use the Consumer Price
Index (CPI) to calculate inflation. Annual rates of change in the WPI calculated
using both the existing and the new series are given below. It is seen that the new
series starts at a higher level than the old series accounting for a relatively higher
annual rate of change, but thereafter the two series virtually move in cycle.

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Main constituents of WPI
1. Primary articles
2. Fuel, power
3. Manufactured products
4. Food articles
5. Vegetables
6. Food products
7. Edible oils
8. Cement

Criteria for Selection of Wholesale Price Outlets

The following criteria were used to determine the wholesale price outlets
1. Popularity of an establishment along the line of goods to be priced
2. Consistency of the stock
3. Permanency of the outlet
4. Cooperativeness of the price informant
5. Location

Measures of inflation in India

Three different price indices are available in India
1. Wholesale price index

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2. Consumer price index [calculated for 3 different types of workers]

Availability
1. The WPI is available weekly [for a lag of 2 weeks]
2. The CPI is available monthly [for a log of 1 month]
3. The GDP deflator is available annually
In many countries, the main focus is placed on CPI for assessing inflationary
trends, because
1. It is the index most statistical resources are placed
2. It is most closely related to the cost of living
In India however the main focus is placed on WPI because it has a broader
coverage and is published on a more frequent and timely basis than the CPI.
However, the CPI remains important because it is used for indexation purposes for
many wage and salary earners.

INDIAN SCENARIO
Inflation is no stranger to the Indian economy. In fact, till the early nineties
Indians were used to double-digit inflation and its attendant consequences. But,
since the mid-nineties controlling inflation has become a priority for policy
framers. The natural fallout of this has been that we, as a nation, have become
virtually intolerant to inflation. While inflation till the early nineties was primarily
caused by domestic factors (supply usually was unable to meet demand, resulting
in the classical definition of inflation of too much money chasing too few goods),
today the situation has changed significantly. Inflation today is caused more by
global rather than by domestic factors. Naturally, as the Indian economy undergoes
structural changes, the causes of domestic inflation too have undergone tectonic
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changes. Needless to emphasize, causes of today's inflation are complicated.
However, it is indeed intriguing that the policy response even to this day
unfortunately has been fixated on the traditional anti-inflation instruments of the
pre-liberalization era.

Reasons for inflation in India

1) Increase in Demand and fall in supply causes rise in prices.
2) A Growing Economy has to pass through Inflation.
3) Lack of Competition and Advanced Technology (increases cost of production
and rise in price)
4) Defective Monetary and Fiscal Policy (In India its fine)
5) Hoarding (when traders hoard goods with intention to sell later at high prices)
6) Weak Public Distribution System

INFLATION PRESSURE OVER THE LAST FEW

MONTHS

Date Inflation Rate

4-Apr-08 7.14
11-Apr-08 7.33
18-Apr-08 7.41
25-Apr-08 7.33
2-May-08 7.57
9-May-08 7.82
16-May-08 8.1
24-May-08 8.24
ECONOMIC ENVIRONMENT
1-Jun-08 BUSINESS 9.75
INFLATION
Page 34
19-Jun-08 10.01
8-Jul-08 11.25
20-Jul-08 11.75
 INFLATION IN INDIA AND OTHER DEVELOPED
COUNTRIES

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 INFLATION DURING 1980’s AND 1990’s

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 WPI inflation was relatively stable between 1983 and 1990, averaging 6 ¾
percent, recording a low of 3 percent in early 1986, and a high of a little over 10
percent in 1988. In the 1990s, inflation has, on average, been higher at 8 ¾ percent,
and considerably more variable. Inflation rose sharply in the early 1990s, reaching
a peak of a little over 16 percent in late 1991, as primary product prices rose
sharply and the balance of payment crisis resulted in a sharp depreciation of the
rupee and upward pressure on the price of industrial inputs. However, as the
agricultural sector rebounded, industrial activity slowed, and financial stability was
restored, inflation declined to 7 percent by mid 1993 but then again accelerated to
over 10 percent during 1994 and 1995 as economic activity recovered strongly. In
response, the RBI moved to tighten monetary policy, and inflation was brought
down gradually, reaching a low of 3 ¾ percent in mid 1997.However, more
recently, inflation again accelerated in the second half of 1998as adverse supply
conditions in key commodity markets put upward pressure on food price. As these
conditions have eased, inflation has again fallen sharply.

GLOBAL INFLATION A COMPARISON WITH INDIA

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 Inflation rates in some developed and developing economies based on the
Consumer Price Indices. Up to the mid 1990s, while inflation rate in the developed
economies ranged between 1-2 percent, it was in a much higher range for the
developing economies including India - with some years even recording double
digit inflation. For exchange rate stability and smoother trade, it is imperative that
inflation rate in India be close to our major trading partners. Over the last three to
four years, we have moved closer to this objective with inflation rate being in the
range 3-5 percent as against 2-3 percent in the developed economies. The declining
trend in inflation is also visible in many of the developing economies in Asia.

ISSUES IN MEASURING INFLATION

Measuring inflation requires finding objective ways of separating out
changes in nominal prices from other influences related to real activity. In the
simplest possible case, if the price of a 10 kgs of corn changes from 90 to 100 over
the course of a year, with no change in quality, then this price change represents
inflation. But we are usually more interested in knowing how the overall cost of
living changes, and therefore instead of looking at the change in price of one good,
we want to know how the price of a large 'basket' of goods and services changes.
This is the purpose of looking at a price index, which is a weighted average of
many prices. The weights in the Consumer Price Index, for example, represent the
fraction of spending that typical consumers spend on each type of goods (using
data collected by surveying households).
Inflation measures are often modified over time, either for the relative
weight of goods in the basket, or in the way in which goods from the present are
compared with goods from the past. This includes hedonic adjustments and
“reweighing” as well as using chained measures of inflation. As with many

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economic numbers, inflation numbers are often seasonally adjusted in order to
differentiate expected cyclical cost increases, versus changes in the economy.
Inflation numbers are averaged or otherwise subjected to statistical techniques in
order to remove statistical noise and volatility of individual prices. Finally, when
looking at inflation, economic institutions sometimes only look at subsets or
special indices. One common set is inflation excluding food and energy, which is
often called “core inflation”.

AN EXAMPLE OF HOW INFLATION CAN BE

DANGEROUS
Hazards of inflation [How Zimbabwe was affected by inflation]
Have you heard of a country which is dotted with malls filled with goods,
but no customers? It is Zimbabwe, the land of Mugabe.
Zimbabwe is a classic case of how inflation can make life hell for people.
Experts say it all started with Mugabe’s regime. Whatever may be the reason, the
basic flaw in Zimbabwe’s economy is that Zimbabwe lost its ability to feed itself.
So, if you don’t have enough agriculture commodities the prices are bound
to go up. This is one lesson India can learn from Zimbabwe.
India’s wheat, rice, pulses and edible oil production is not enough to keep
pace with the growth the country is witnessing. That is why Indian government is
worrying about the rising inflation rates.
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 However, it is not anywhere near Zimbabwe. Zimbabwe’s skyrocketing
inflation – now the world’s highest, running at more than 100,000 per cent a year –
keeps the cost of living rising.
In 1979, when Mugabe’s nationalist rebels overthrew the white-dominated
government of Rhodesia, and changed the name of the country to Zimbabwe,
thousands of commercial farms managed to grow enough food to export
throughout the region.
At present, more than a decade of mismanagement and neglect has dropped
agricultural production to pre-colonial levels.
This year, Zimbabwe’s shortfall in maize is 360,000 tonnes, and its shortfall
in wheat is 255,000 tonnes.
Streets of Zimbabwe are dotted with shopping mall. That shows that there is
food on the shelves, but all of it highly priced.
Massive department stores, built for a time when farmers from miles around
would come to do their weekend shopping, are full of clothes, but without
customers.
With cash almost a worthless possession, people have started investing in
something different. They stack bags of maize meal in their homes.
The situation in Zimbabwe has hit several Indians badly. Many of the Indian
businessmen in Zimbabwe, especially Gujaratis, are finding it tough to do trade
there.
Because, a sausage sandwich sells for 30 million Zimbabwe dollars, or about
US $1.25. A 30-pound bag of potatoes cost 90 million in the first week of March.
Now that same bag costs 160 million.
So, Zimbabwe is an example for the world how inflation can ruin a country,
which does not produce enough food for itself.

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 RESERVE BANK OF INDIA
The central bank of the country is the Reserve Bank of India (RBI). It was
established in April 1935 with a share capital of Rs. 5 crores on the basis of the
recommendations of the Hilton Young Commission. The share capital was divided
into shares of Rs. 100 each fully paid which was entirely owned by private
shareholders in the beginning. The Government held shares of nominal value of
Rs. 2, 20,000.
Reserve Bank of India was nationalized in the year 1949. The general
superintendence and direction of the Bank is entrusted to Central Board of
Directors of 20 members, the Governor and four Deputy Governors, one
Government official from the Ministry of Finance, ten nominated Directors by the
Government to give representation to important elements in the economic life of
the country, and four nominated Directors by the Central Government to represent
the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New
Delhi. Local Boards consist of five members each Central Government appointed
for a term of four years to represent territorial and economic interests and the
interests of co-operative and indigenous banks.
The Reserve Bank of India Act, 1934 was commenced on April 1, 1935.
The Act, 1934 (II of 1934) provides the statutory basis of the functioning of the
Bank.
The Bank was constituted for the need of following:
 To regulate the issue of bank notes
 To maintain reserves with a view to securing monetary stability and
 To operate the credit and currency system of the country to its advantage.

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 FUNCTIONS OF RESERVE BANK OF INDIA
1. To maintain monetary stability so that the business and economic life can
deliver welfare gains of a properly functioning mixed economy.
2. To maintain financial stability and ensure sound financial institution so that
monetary stability can be safely pursued and economic units can conduct
their business with confidence.
3. To maintain stable payments system so that financial transactions can be
safely and efficiently executed.
4. To promote the development of financial infrastructure of markets and
systems, and to enable it to operate efficiently i.e., to play a leading role in
developing a sound financial system so that it can discharge its regulatory
function efficiently.
5. To ensure that credit allocation by the financial system broadly reflects the
national economic priorities and societal concerns.
ROLE OF RBI
The Reserve Bank of India Act of 1934 entrust all the important functions of
a central bank the Reserve Bank of India.
1] Bank of Issue
Under Section 22 of the Reserve Bank of India Act, the Bank has the sole
right to issue bank notes of all denominations. The distribution of one rupee notes
and coins and small coins all over the country is undertaken by the Reserve Bank
as agent of the Government. The Reserve Bank has a separate Issue Department
which is entrusted with the issue of currency notes. The assets and liabilities of the
Issue Department are kept separate from those of the Banking Department.
Originally, the assets of the Issue Department were to consist of not less than two-
fifths of gold coin, gold bullion or sterling securities provided the amount of gold
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was not less than Rs. 40 crores in value. The remaining three-fifths of the assets
might be held in rupee coins, Government of India rupee securities, eligible bills of
exchange and promissory notes payable in India. Due to the exigencies of the
Second World War and the post-war period, these provisions were considerably
modified. Since 1957, the Reserve Bank of India is required to maintain gold and
foreign exchange reserves of Ra. 200 crores, of which at least Rs. 115 crores
should be in gold. The system as it exists today is known as the minimum reserve
system.

2] Banker to Government
The second important function of the Reserve Bank of India is to act as
Government banker, agent and adviser. The Reserve Bank is agent of Central
Government and of all State Governments in India excepting that of Jammu and
Kashmir. The Reserve Bank has the obligation to transact Government business,
via. to keep the cash balances as deposits free of interest, to receive and to make
payments on behalf of the Government and to carry out their exchange remittances
and other banking operations. The Reserve Bank of India helps the Government -
both the Union and the States to float new loans and to manage public debt. The
Bank makes ways and means advances to the Governments for 90 days. It makes
loans and advances to the States and local authorities. It acts as adviser to the
Government on all monetary and banking matters.

3] Bankers' Bank and Lender of the Last Resort

The Reserve Bank of India acts as the bankers' bank. According to the
provisions of the Banking Companies Act of 1949, every scheduled bank was
required to maintain with the Reserve Bank a cash balance equivalent to 5% of its

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demand liabilities and 2 per cent of its time liabilities in India. By an amendment
of 1962, the distinction between demand and time liabilities was abolished and
banks have been asked to keep cash reserves equal to 3 per cent of their aggregate
deposit liabilities. The minimum cash requirements can be changed by the Reserve
Bank of India. The scheduled banks can borrow from the Reserve Bank of India on
the basis of eligible securities or get financial accommodation in times of need or
stringency by rediscounting bills of exchange. Since commercial banks can always
expect the Reserve Bank of India to come to their help in times of banking crisis
the Reserve Bank becomes not only the banker's bank but also the lender of the last
resort.

4] Controller of Credit
The Reserve Bank of India is the controller of credit i.e. it has the power to
influence the volume of credit created by banks in India. It can do so through
changing the Bank rate or through open market operations. According to the
Banking Regulation Act of 1949, the Reserve Bank of India can ask any particular
bank or the whole banking system not to lend to particular groups or persons on the
basis of certain types of securities. Since 1956, selective controls of credit are
increasingly being used by the Reserve Bank.
The Reserve Bank of India is armed with many more powers to control the
Indian money market. Every bank has to get a licence from the Reserve Bank of
India to do banking business within India, the licence can be cancelled by the
Reserve Bank of certain stipulated conditions are not fulfilled. Every bank will
have to get the permission of the Reserve Bank before it can open a new branch.
Each scheduled bank must send a weekly return to the Reserve Bank showing, in
detail, its assets and liabilities. This power of the Bank to call for information is

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also intended to give it effective control of the credit system. The Reserve Bank
has also the power to inspect the accounts of any commercial bank. As supreme
banking authority in the country, the Reserve Bank of India, therefore, has the
following powers:
(a) It holds the cash reserves of all the scheduled banks.
(b) It controls the credit operations of banks through quantitative and qualitative
controls.
(c) It controls the banking system through the system of licensing, inspection and
calling for information.
(d) It acts as the lender of the last resort by providing rediscount facilities to
scheduled banks.

5] Custodian of Foreign Reserves

The Reserve Bank of India has the responsibility to maintain the official rate
of exchange. According to the Reserve Bank of India Act of 1934, the Bank was
required to buy and sell at fixed rates any amount of sterling in lots of not less than
Rs. 10,000. The rate of exchange fixed was Re. 1 = sh. 6d. Since 1935 the Bank
was able to maintain the exchange rate fixed at lsh.6d. though there were periods of
extreme pressure in favour of or against the rupee. After India became a member of
the International Monetary Fund in 1946, the Reserve Bank has the responsibility
of maintaining fixed exchange rates with all other member countries of the I.M.F.
Besides maintaining the rate of exchange of the rupee, the Reserve Bank has to act
as the custodian of India's reserve of international currencies. The vast sterling
balances were acquired and managed by the Bank. Further, the RBI has the
responsibility of administering the exchange controls of the country.

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6] Supervisory functions
In addition to its traditional central banking functions, the Reserve bank has
certain non-monetary functions of the nature of supervision of banks and
promotion of sound banking in India. The Reserve Bank Act, 1934, and the
Banking Regulation Act, 1949 have given the RBI wide powers of supervision and
control over commercial and co-operative banks, relating to licensing and
establishments, branch expansion, liquidity of their assets, management and
methods of working, amalgamation, reconstruction, and liquidation. The RBI is
authorized to carry out periodical inspections of the banks and to call for returns
and necessary information from them. The nationalization of 14 major Indian
scheduled banks in July 1969 has imposed new responsibilities on the RBI for
directing the growth of banking and credit policies towards more rapid
development of the economy and realization of certain desired social objectives.
The supervisory functions of the RBI have helped a great deal in improving the
standard of banking in India to develop on sound lines and to improve the methods
of their operation.
7] Promotional functions
With economic growth assuming a new urgency since Independence, the
range of the Reserve Bank's functions has steadily widened. The Bank now
performs a variety of developmental and promotional functions, which, at one
time, were regarded as outside the normal scope of central banking. The Reserve
Bank was asked to promote banking habit, extend banking facilities to rural and
semi-urban areas, and establish and promote new specialized financing agencies.
Accordingly, the Reserve Bank has helped in the setting up of the IFCI and the
SFC; it set up the Deposit Insurance Corporation in 1962, the Unit Trust of India in
1964, the Industrial Development Bank of India also in 1964, the Agricultural

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Refinance Corporation of India in 1963 and the Industrial Reconstruction
Corporation of India in 1972. These institutions were set up directly or indirectly
by the Reserve Bank to promote saving habit and to mobilize savings, and to
provide industrial finance as well as agricultural finance. As far back as 1935, the
Reserve Bank of India set up the Agricultural Credit Department to provide
agricultural credit. But only since 1951 the Bank's role in this field has become
extremely important. The Bank has developed the co-operative credit movement to
encourage saving, to eliminate moneylenders from the villages and to route its
short term credit to agriculture. The RBI has set up the Agricultural Refinance and
Development Corporation to provide long-term finance to farmers.

CONTROL MEASURES OF RBI

RBI actually has four chief weapons in its arsenal to control the inflation. They are
1. Open Market Operations (OMO)
2. Reserve Requirements (CRR and SLR)
3. Bank Rate or Discount rate
4. Repo rate

1. Open Market Operations (OMO)

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 In this case RBI sells or buys government securities in open market
transaction depending upon whether it wants to increase the liquidity or reduce it.
So when RBI sells government securities in secondary market it sucks out the
liquidity (stock of money) in the economy. So overall it reduces the money supply
available with banks in effect the capital available with banks for lending purpose
becomes scarce hence interest rates move in upward direction. Exactly opposite
happens when RBI buys securities from open market. The transaction increases the
money supply available with banks so the cost of money (interest rate) moves in
downward direction and business activities like new investments, capacity
expansion gets boost. In a nutshell RBI buys securities when the economy is
sluggish and demand is not picking up and sells securities when the economy is
overheated and needs to cool down. OMO is also used in curbing the artificial
liquidity created to avoid strengthening of rupee against dollar in order to remain
competitive in exports.

2. Reserve Requirements
This mainly constitute of Cash to Reserve Ratio (CRR) and Statutory
Liquidity ratio (SLR). CRR is the portion of deposits (as cash) which banks have to
keep/maintain with the RBI. This serves two purposes firstly, it ensures that a
portion of bank deposits is totally risk-free and secondly it enables that RBI control
liquidity in the system, and thereby, inflation. Whereas SLR is the portion of their
deposits banks are required to invest in government securities. So due to CRR and
SLR obligation towards RBI financial institutions will be able to lend only the part
of money available with them although this effect is small when transaction is

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between just two entities and constitute one layer. But when money flows through
series of players and layers very less money will be left with the institutions
present at the bottom of pyramid. So higher is the CRR less is the money available
in the economy. So interest rates will move in upward direction and opposite
happens when CRR is reduced. Recently RBI raised CRR from 4.5% to 5% in two
stages which enabled to transfer about 8000 Crore rupees from money in supply to
RBI’s coffers. CRR has actually been reduced to this level of 5% from 15% in
1981.

3. Bank Rate or Discount rate

This is the rate at which the RBI makes very short term loans to banks.
Banks borrow from the RBI to meet any shortfall in their reserves. An increase in
the discount rate means the RBI wants to slow the pace of growth to reduce
inflation. A cut means that the RBI wants the economy to grow and take up new
ventures. Indian bank rate is at 6 per cent down from 10 per cent in 1981 and 12
per cent in 1991.

4. Repo rate
It is the rate at which the RBI borrows short term money from the market.
After economic reforms RBI started borrowing at market prevailing rates. So it
makes more sense to banks to lend money to RBI at competitive rate with no risk
at all. Although the repo rate transactions are for very short duration the everyday
quantum of operations is approximately Rs 40,000 crore everyday. Thus, large
amount of capital is not available for circulation. With increase in repo rate banks
tend to invest more in repo transactions.

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 Open market operations have limitations due to amount of government
securities with RBI is limited and close to Rs 60,000 Crore and out of that only Rs
45,000 Crore is in form of marketable securities. Considering Bank Rate which is
untouched in current scenario RBI is left with only 2 major measures viz.
CRR and Repo Rate in its armory to guard against the onslaught of inflation.
Since large part of inflation is attributed to large increase in international oil and
metal prices, the cooling price trend in them comes as a great relief to RBI and
Indian economy as a whole and along with RBI measures has helped stabilize
inflation.

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 MONETARY POLICY
The Reserve bank of India, being primarily concerned with money matters,
so organize currency and credit that it subs serves the broad economic objectives of
the country. In the performance of this task, it formulates and executes a monetary
policy with clear cut goals and tools to be used for this.
Monetary Policy of RBI
Reserve Bank of India focuses on the following main six basic goals of monetary
policy
 High employment
 Economic growth
 Price stability
 Interest-rate stability
 Stability of financial markets
 Stability in foreign exchange markets

Limitation of Monetary Policy

While examining the working of the monetary policy. It is important
remember that there are some limitations on its successful application. These
limitations on its successful application. These limitation mostly arise from the
under developed character of the economy, as also from certain shortcomings of
the economic situation obtaining in the country.
1. Restricted scope of policy
2. Predominance of currency
3. Underdeveloped money market
4. Existence of black money

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5. Government policies
CONCLUSION

Inflation is not simply a matter of rising prices. There are endemic and
perhaps diverse reasons at the root of inflation. Cost-push inflation is a result of
decreased aggregate supply as well as increased costs of production, itself a result
of different factors. The increase in aggregate supply causing demand-pull inflation
can be the result of many factors, including increases in government spending and
depreciation of the local exchange rate. If an economy identifies what type of
inflation is occurring (cost-push or demand-pull), then the economy may be better
able to rectify (if necessary) rising prices and the loss of purchasing power.

Inflation is just like a man whose behaviour cannot be predicted and one can say
that as man has two faces, similarly Inflation can also be said to have Positive and
Negative faces on Indian Economy.

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